THE US REAL ESTATE INDUSTRY

Real estate plays a vital role in the US economy. Following are some of the facts and
figures that show the importance of the real estate sector to the overall US economy,
according to a report as of February 2005 prepared by Economic Intelligence Company:

 In 2002, the real estate industry employed 1.56 million people in its various
segments.
 Over the past two decades employment in real estate has grown more rapidly than
the general economy. Since1982, employment in the real estate industry has
increased more than 60%, far more than the 46% increase in total employment.
 In 2001, the real estate industry generated more than $66 billion in compensation
for its employees. That makes it one of the largest income producing industries in
the country.
 The total value of commercial real estate in the US as estimated by the
Department of Commerce is $3.54 trillion dollars.
 Since 1992, the value of commercial real estate has increased by 67.5%, while
GDP has increased by only 59.6%
 The value of all real estate in the US is larger than the total GDP of every country
in the world except Japan. In fact, the total value of commercial real estate in the
US is roughly equal to the annual output of Germany, France, Sweden and
Switzerland combined.
 In 2001, the real estate industry generated $326.6 billion in output, accounting for
3.24% of the total output of goods and services in the US economy.
 The commercial real estate industry contributes more to the US economy than
many other large industries. In 2005, real estate’s contribution to GDP was almost
three times as large as the motor vehicle industry, twice as large as the chemicals
industry and larger than the communication or transportation sectors.

Real Estate Property Types:

The two major types of real estate property are:
  Residential Properties
 Commercial Properties

Residential Properties:
idential properties include single family houses and multifamily properties such as
apartments. Condominiums and co-ops are also included as residential property. In
general, residential properties are properties that provide residences for individuals or
families.

Single family houses are usually individual, detached units. Multifamily housing is
differentiated by location (urban or suburban) and size of structure (high rise, low rise, or
garden apartments. High rise apartments are usually found near or close to the central
business district of cities because land costs are greater than suburban areas.

Commercial Properties:
Commercial properties are typically broken down into five major subcategories:
 office,
 retail,
 industrial,
 hotel/ motel,
 recreational and
 institutional.

Office buildings range from major multi-tenant buildings found in the central business
district of most large cities to single tenant buildings, often built with the needs of a
specific tenant or tenants in mind.

Retail properties vary from large regional shopping containing over million square feet
of space to small stores with single tenants.
Industrial real estate includes property used for light or heavy manufacturing as well as
associated warehouse space. This category includes special – purpose buildings designed
specifically for industrial use that would be difficult to convert to another use, buildings
used by wholesale distributors, and combinations of warehouse/ showroom and office
facilities. Older buildings that were initially used as office space often become warehouse
or light industrial space.

Hotels and motels vary considerably in size and facilities available. Motels and smaller
hotels are used primarily as a place of business travelers and families to spend a night.
These properties may have limited amenities, such as swimming pools, dining facilities,
or meeting space. The property will often be located very close to a minor highway.
Hotels designed for tourists who plan to stay longer will usually provide dining, a
swimming pool, and other amenities. They are also typically located near other
attractions that tourists visit. Hotels at destination resorts provide the greatest amount of
amenities. Hotels are of various types such as discount or budget, extended stay, mid-
price, full service, limited service, suites, luxury.

Recreational real estate includes uses such as country clubs, marinas, sports complexes,
and so on. These are very special uses, usually associated with retail space that
compliments the recreational activity. Dining facilities and hotel facilities may also be
present.

Institutional real estate is a general category of property that is used by a special

institution such as a government agency, a hospital or a university. The physical structure
could be similar to other properties; government office space for example, would be
similar to other offices, and could in fact be in the same building. However, space used
by institutions such as universities and hospitals is usually designed for a specific purpose
and are not easily adaptable for other uses.
 INCOME STREAMS FROM COMMERCIAL PROPERTY TYPES

COMMERCIAL OFFICE
Revenues:
The primary source of revenue for a commercial office building is rent. However all
things being equal desirability or the demand for a particular office building governs the
rents it can command within a class. Desirability is primarily a function of location. Other
sources of revenue for an office building include reimbursement of operating costs. These
are subject to annual adjustments. Office building owners receive other forms of income
such as building services income and even percentage rents from other retail tenants.

Expenses:
Expenses are incurred to operate and maintain a building occupied by tenants. Major
office building costs include –

Cleaning and custodial supplies

Repairs and maintenance costs
General and administrative expenses
Management fees and leasing commissions
Utilities
Property taxes
Insurance
Such costs are referred to as Operating expenses

RETAIL:
Revenues:
The rental income of a shopping center comes from base rent and percentage rent. One of
the primary sources of other income for a retail center is income related to the pass
through of Common Area Maintenance (CAM). CAMs are those that relate to the center
as a whole and therefore relate to each retail tenant.
Expenses:
Operating costs of a shopping center are much smaller, in terms of magnitude, than those
incurred by a commercial office building. This occurs because the tenants in a retail
center pay many of the operating costs, including utilities for which they are usually
separately metered. Management fees are generally low for a retail property since less
work is involved from an administrative and management standpoint.

MULTIFAMILY:
Revenues:
The income from apartments is generally rent. Depending on the facilities, there may be
some ancillary income from laundry, parking, vending, interest and the rental of special
facilities- recreational facilities or club houses. Apartments do not charge the common
area maintenance pass throughs that one finds in retail. There is no need for such pass
throughs, since the leases are short term and are subject to constant adjustment as leases
roll over.

Apartments differ from most forms of real estate ownership in the requirement for
security deposits.

Expenses:
Expenses run into same broad categories found in any commercial property including
repairs and maintenance, taxes and utilities, insurance, management fees and
administrative charges. Certain repair and maintenance charges relate to items that are
funded from a reserve and are therefore not considered as ordinary operating expenses.
Management fees run from 2.5% to 5% depending on market conditions and the owners
of the property

INDUSTRIAL:
Revenues:
The basic revenue of an industrial project is rent. Again, product type, construction, area
demographics, amenities, location and market perception drive industrial rental revenues.
Since many industrial buildings or parks serve as distribution or warehouse facilities,
building or park accessibility to various forms of transportation may also impact the rent
charged. There may be some pass through of expenses.

Expenses:
The expenses of an industrial warehouse project fall into some major categories found in
the other commercial property types- insurance, taxes and operating costs. Operating
costs of such facilities are fairly low and the tenants often bear a great deal of the
operating costs since the operations contained within the industrial space belong to the
tenant and not the landlord. The landlord incurs taxes, subject to pass through. The
landlord also incurs casualty insurance costs for the building and general liability
insurance.

HOTELS:
Income:
Hotels earn revenues from the range of services that they offer. Depending on the hotel’s
services, revenues could include catering, meetings conventions, office services,
gambling or golf revenues.

Expenses:
The expenses other than those in the cost of sales category are generally the same found
with any real estate project. Since many hotels are franchises, a franchise fee may also be
paid to the franchisor.

Major Participants In The Real Estate Industry

Developers:
Development is an idea that comes to fruition when consumers – tenants or owner –
occupants acquire and use the space put in place by the development team. Land, labor,
capital management and entrepreneurship are needed to transform an idea into reality.
Developers balance the needs of diverse providers and consumers of the real estate
product. The developers have to demonstrate the project’s feasibility to the capital
markets and pay interest or assign Equity positions in return for funding.

Appraisers:
Appraisers can be a part of every stage of the property development process. Appraisers
are primarily responsible for valuation of the project. They estimate the market value of
the property and typically prepare a formal document called appraisal. Appraisals may be
necessary when a developer transfers ownership, seeks financing and credit, resolves tax
matters, and establishes just compensation in condemnation in condemnation
proceedings. Appraisers can also evaluate a project as input to market studies and
feasibility studies.

The total number of appraisers registered with the National Appraisal Institute, USA is
approximately 100,000 as of September 2002. Some of the familiar names in the US Real
Estate markets include CB Richard Ellis, Cushman and Wakefield and Grubb and Ellis.
Property managers:
Property mangers focus on the day to day operation of the asset. Property managers carry
responsibility for all respects of the physical space in accordance with the asset
manager’s plan. The responsibilities of a property manager include:

• Marketing and leasing

• Maintenance and repair
• Tenant relations including rent collection
• Insurance
• Accounting
• Human resource Management
• Providing timely information to the asset manager about events affecting the
property.

Some of the major property managers include Trammel Crow Company and Grubb and
Ellis Company.

Brokers/ Leasing Agents:

Real Estate brokers and leasing agents are hired to act in the name of the developer in
leasing and selling space to prospective tenants or buyers. Their function, particularly in
leasing large industrial and commercial spaces is to carry out one of the most complex
financial negotiations in the development process. Leasing agents must balance all the
various users’ individual needs against the developer’s financial model.

Lenders:
Construction Lenders are usually commercial banks which are responsible for financing
during project construction and for seeing that the developer completes the project within
the budget and according to the specifications. Construction lenders faced the risk that
construction costs will exceed the construction loan that they have agreed to provide,
requiring the developer to cover the difference.
Permanent lenders seek to originate safe loans generating the maximum possible return.
The market value of the completed project is very critical in that it serves as the primary
collateral for the loan.
REITs (Real Estate Investment Trusts) are an efficient way for many investors to
invest in commercial and residential real estate businesses. REITs own and in many cases
operate income producing real estate such as apartments, shopping centers, offices, hotels
and warehouses. REITs were created in 1960 to make investments in large scale income
producing real estate accessible to small investors. A company to qualify as a REIT must
comply with certain provisions within the Internal Revenue Code. There are about 300
REITs operating in the United States. In addition there are several REITs that are not
traded on a stock exchange. REITs can be classified as Equity REITs, Mortgage REITs
and Hybrid REITs. REITs are managed like other publicly managed companies.

At the end of 2002, the market capitalization of all REITs in the US reached a record high
of $161.9 billion. At the end of 2002 there were 176 REITs operating in the US

Portfolio Managers:
Portfolio Managers view assets in a larger context than only one asset. For Real Estate
investments, managers are concerned about the return and risk of single property
investment opportunities and how they affect the performance of both the entire mixed-
asset portfolio and the component real asset portfolio.
Boundaries Of The Market:
The US Real Estate market extends across the fifty states which are grouped into six
Census regions.

Direct Capitalization Model:

This technique is a very simple approach to the valuation of income-producing property.
It is based on the idea that any given point in time the current NOI produced by a
property is related to its current market value. Symbolically,

NOI1
R = -------
V
Where NOI1 is net operating income in the first year of the holding, as developed from
the operating statement, V is the property value and R is the capitalization rate.

Calculation of the direct cap rate:

Example:
Comparable Sale Sale Price NOI
1. $1,400,000 $145,000
2. $1,350,000 $150,000

The capitalization rate on the first sale is $145,000 / $1,400,000 = 0.104 and on the
second sale is $150,000 / $1,350,000 = .111. The weighted average of the two cap rates is
about 0.1075. Assuming that the above two properties are similar to one another and to
the subject property, this average can be used as the direct cap rate to find out the value
of the subject property.

Discounted Cash flow model: n

The present value method involves projecting the NOI for the property over a typical
investment holding period. When projecting over a holding period, the resale value of the
property at the end of the holding period must also be estimated. The discount rate must
reflect a competitive investment yield for the type of property being valued. That is, it
should be a rate that the typical investor would normally require as a minimum return
over the life of the investment to be willing to purchase the property. One guide for the
discount rate would be the interest rate on a mortgage for the same property plus a risk
premium for ownership (equity).

The present value of an income stream that is increasing at a compound growth rate ‘g’ as
a perpetuity is found as follows:

V = NOI1 / (r-g)
where,
V = Present value of the income stream
NOI1 = the first year income (NOI)
g = annual growth in income
r = discount rate for present value

Holding period: Investors typically hold assets for a period that is lesser than the entire
economic life of the asset. The property obviously must be sold at the end of the holding
period subject to any leases that extend beyond the holding period. In such a situation, the
value at which the property would be sold at the end of the holding period should be
determined.

Reversionary value:
The reversionary value of the property is calculated by applying the terminal cap rate
over the income projected for the year following the holding period.
Example:

V10 = NOI11 / Terminal Cap Rate

Where,
Holding period = 10 years
V10 = Value at the end of the tenth year
NOI11 = NOI of the eleventh year
Calculation of the property value:
The reversionary value along with the income streams expected during the holding period
are discounted to find the present value of all the cash flows expected during the holding
period.

In theory, the estimated value of the property under all the three approaches should be
equal. But, in practice, there is always a discrepancy between the values estimated under
different approaches. So it is left to the judgment of the appraiser to conclude the final
value of the property by assigning appropriate weights to the values calculated under the
different approaches. For instance, according to the FHA guidelines, the sales comparison
approach has the most weight when determining the market value of a home that is to be
insured by an FHA loan.

Another viewpoint is that when the estimates of value under the direct cap approach and
DCF approach diverge, it is better to rely on the results of the DCF analysis for two
reasons. First, DCF models force the analyst to make explicit assumptions about the
future income streams and the sales price assumptions that finally generates the present
value of the property. Second, the use of a direct cap rate assumes that the properties
from which the cap rate was extracted were very similar to the one being valued.
Measures Of Investment Performance Based On Cash Flow Projections:

Net Present Value (NPV):

To find the NPV, first the present value (PV) of all the estimated future cash flows. Then
the initial cash outlay invested to acquire this investment is subtracted from this present
value to obtain the net present value.

NPV = Present Value of cash inflows - Present Value of cash outflows

Thus, NPV measures the extent, if any, that the present value of cash flows to be received
from the investment exceeds the equity invested in the property. A positive NPV
indicates that the value of the investment in present value terms exceeds the equity
investment. The NPV obviously depends on the discount rate used to calculate the
present value of cash inflows. This discount rate should reflect the minimum rate of
return that the investor requires to make the investment, considering the risk of the
investment. NPV is an opportunity cost concept in that the return required for the
investment being analyzed should be at least as good as the return available on
comparable investments. By investing in the properties being analyzed, the investor must
forgo the return that could have been earned on alternative investment opportunities.
Internal Rate of Return:
The investment yield or IRR is the discount rate that equates the present value of the
future cash inflows with the initial cash outflow.

3.2 EVALUATION PARAMETERS

A. Loan To Value
B. Debt Service Coverage Ratio
C. Credit Tenants
D. Lease Rollover Risk
E. Location

A. Loan To Value

One of the factors lenders consider before they approve a mortgage is the loan-to-
value ratio (LTV). The LTV is the loan amount expressed as a percent of either the
purchase price or the appraised value of the property. So, if you make a 20 percent cash
down payment on a property you're buying, the LTV is 80 percent. Or, if you're buying a
property for $25 0,000 and the mortgage amount is $200,000, the LTV is 80 percent (the
$200,000 loan amount divided by the $250,000 purchase price).

A mortgage with a high LTV is one where the mortgage amount is high relative to
the borrower's cash down payment or to the equity in the property. For example, if the
LTV is 95 percent, the mortgage amount is equal to 95 percent of the purchase price and
the buyer's cash down payment is equal to only 5 percent of the price. From a lender's
perspective, a high LTV mortgage is more risky than one where the LTV is low. When
borrowers make a large cash down payment, or have a large equity in a property, they are
less likely to default on the mortgage. Borrowers with less equity in a property have less
to lose which puts lenders more at risk.

B. Debt Service Coverage Ratio

The debt service coverage ratio (DSCR) is the NOI divided by debt service.

DSCR = NOI
----------------
Debt Service
The DSCR is indicative of the ability of the property’s income stream to service the loan.
The lender fixes a minimum required DSCR that is expected from a property which is to
be financed. The DSCR projections over the loan period are compared against this
benchmark and the risk associated with the property’s income streams is assessed.

C. Credit Tenants
Credit Tenants are those tenants whose creditworthiness is high and default risk is almost
nil. Credit tenants play a major role in retail properties. They also play the role of anchor
tenants who attract more customers than an ordinary tenant. These tenants are usually
rated by Credit Rating Agencies like Standards & Poor’s and Moody’s .The concept of
credit tenants plays an important role in risk – return analysis and in valuation. Therefore
the number of credit tenants in retail properties and their contribution to the revenue helps
us in determining the profitability of the proposal. The more the credit tenants and the
area occupied by them the lesser the risk.

Table 3.1 Credit Rating Table

General Credit Quality Standard & Poors Moody's

AAA AAA
AA+ AA1
AA AA2
AA- AA3
A+ A1
A A2
A- A3
INVESTMENTGRADE
BBB+ Baa1
BBB Baa2
BBB- Baa3
BB+ Baa1
BB Baa2
BB- Baa3

B+ Ba1
B Ba2
NON-INVESTMENT GRADE B- Ba3
 D. Lease Rollover risk

Rollover is the probability that an existing tenant might continue to occupy the space. It is
a risk to the owners of the building and to the lenders. Incase of a rollover, the landlord
has to take some efforts to bring in new tenants to the building. The occupancy of the
building depends on various factors like location, market rent, anchor tenants existing in
the building and the various demand & supply factors. This is a risk. If the landlord is
unable to bring in a tenant within the stipulated time, it might result in downtime leading
to vacancy in the building. This would affect the Debt Service of the borrower in turn
affecting the lender. Thus the rollover risk has to be considered before evaluating the
proposals for retail properties. The longer the rollover, lesser is the risk.